June 25, 2018

A few years ago as I was finishing up my book Economics Rules: The Rights and Wrongs of the Dismal Science (Norton 2015), I realized that the manuscript contained a serious omission. I had written at length about how and why economists misuse the powerful tools of their discipline, but had said little about the successes. So I decided I would open the book with three vignettes of economics at its best. Each vignette would have its hero: an economist who combined economic models with real-world judgement to make life better for lots of people.

Santiago Levy was one of the three heroes I chose. (The names of the other two heroes will let the reader gauge how demanding was the standard I applied: John Maynard Keynes and William Vickrey.) Santiago was the principal force behind the anti-poverty program Progresa in Mexico that quickly became a model for many other countries. This was an innovative, incentive-based program that was novel at the time, in 1997. It replaced inefficient price subsidies with direct cash grants to poor families as long as their children were kept in school and received periodic health checks. So successful was the program that subsequent Mexican political administrations would seek credit for it by renaming it; hence Progresa would turn into Oportunidades, which eventually became Prospera.

When sound economics is combined with a practical, pragmatic bent it can be a potent force for good. There are very few people who are as good a living embodiment of this as Santiago Levy. I learned this a very long time ago, during the late 1980s, when I found myself on a visit with him to Bolivia. We were both young and inexperienced. But what stood out with him, even back then, was an imaginativeness and creativity in policy that were sorely missing from the academic literature I was steeped in. I don’t remember much about our assignment, but I have vivid memories of Santiago bursting with out-of-the-box ideas.

Santiago has been puzzling for a very long time about the paradoxes of Mexico’s economic performance. And what a major puzzle the country poses to received wisdom about development policy!

The country has made major strides in social progress – thanks not least to Santiago’s own efforts as policy maker and advisor. School attendance has increased greatly, while educational quality has improved. Fiscal and monetary policies have ensured a stable macroeconomy and have kept financial crises at bay. No country has tried harder to integrate into the world economy. And yet in overall productivity, the gains have been very meager. Since 1996, Mexico’s economy has expanded at barely over 1 percent per year in per-capita terms, and labor productivity has grown at less than 0.5 percent.

Santiago points his finger to the persistent (and worsening) misallocation of resources as the culprit for Mexico’s poor productivity performance. Simply put, labor and capital do not go to the most productive firms. The best performing firms in Mexico are doing very well indeed – in all respects except for increased employment. The underperformance of the less productive parts of the economy undoes whatever progress the better performing parts generate.

Santiago’s conclusions are based on a rich, firm-level analysis using census and employment data and covering millions of firms since the late 1990s to 2103. He documents that productive heterogeneity actually increased over this time: there is more informality, larger productive differences, and greater gaps in firm size. But this is not a simple and oft-told story of formal versus informal sectors. Santiago shows that the constitutionally-mandated difference between “salaried” and non-salaried” workers does more of the work in accounting for misallocation than the traditional formal/informal divide. For example, small or informal firms need not be less productive than large firms if they are employing salaried workers (albeit illegally).

Santiago Levy’s meticulous diagnostic work leads him to conclude that the policy failures behind these patterns are highly specific to Mexico. He draws attention in particular to three different facets of the Mexican policy environment: social insurance mechanisms, tax policies, and poor contract enforcement. Together, these elements conspire to produce a disproportionate burden on formal, large, salaried firms while effectively subsidizing non-salaried workers. He shows that these policies have had larger adverse effects over time in recent decades. Santiago emphasizes that this is not a book policy. But readers will find a rich policy menu here, targeted at real problems of productivity.

The thesis of the book is as challenging as it is fascinating. It is not only a rebuke to the standard view that open trade, stable macroeconomics, or investment in human capital are enough to generate rapid growth. Santiago also argues the attempt to provide broad social insurance to the Mexican people has backfired by taxing the more organized, more productive segments of the economy.

This is applied development economics at its best. We would not expect less from Santiago Levy.